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Weekday Trader Extra

Caesars: Is Worst Over?

By

Andrew Bary

August 5, 2014

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The battle is heating up between Apollo Global Management and TPG Capital, the big private-equity firms that control Caesars Entertainment (ticker:
CZR
), and a group of Caesars bondholders that includes some well-known hedge funds, including Appaloosa Management and Oaktree Capital.

Appaloosa is run by David Tepper, who made his name in the distressed-debt and high-yield markets. Oaktree is headed by Howard Marks, another distressed-debt maven. Apollo CEO Leon Black, a pioneer in junk debt, is a formidable rival.

The bondholder group, which holds a sizable chunk of more than $5 billion of second-lien debt issued by a heavily leveraged Caesars Entertainment Operating Co. (CEOC), a Caesars subsidiary, late Monday sued Caesars in the Delaware Court of Chancery, arguing that Caesars fraudulently transferred casino and other assets from CEOC to less-leveraged entities controlled by Caesars. The situation is very complicated financially and difficult to handicap.

The suit could be a move to try to wrest greater concessions from Caesars in the likely restructuring of CEOC's $19 billion of debt. The second-lien bondholders aren't in a strong position based on asset coverage and their debt (including the 10s of 2018) has fallen sharply in the past two months to 30 cents on the dollar from 40 cents on the dollar—they fetched around 50 at year-end 2013.

Caesars reportedly is in talks with CEOC's first-lien bondholders and the second-lien bondholders may fear that any deal with the first-lien holders could leave little or nothing for them. The first-lien holders appear to be in good shape based on asset coverage and as a result, that debt (including the 9s of 2020) trades for 85 to 90 cents on the dollar.

Equity investors are clearly rattled by the latest actions because Caesars shares fell 10% today to close at $12.71, after earlier today hitting a 52-week low of $12.21. Shares are down about 30% since the end of June.

The weakness in Caesars shares appears to reflect a couple concerns. One of the main risks is that any restructuring of CEOC could involve significant issuance of equity in Caesars Entertainment to the second-lien bondholders, thus diluting existing shareholders. Caesars Entertainment now has a market value of about $1.8 billion with roughly 144 million outstanding shares. Additionally, the second-lien holders could succeed in voiding a series of transactions in the past year and thwart Caesars restructuring efforts.

Barron's wrote about the likelihood of a battle over Caesars in the spring (see Feature, "Financial Bigs Face Off in the Ring at Caesars," April 10). In that article, we argued that Caesars shares looked overvalued at around $19 due to several risks, including a reversal of the asset sales, sizable equity dilution and the remote possibility that the entire value of Caesars could be attached by creditors. Since then, shares have lost a third of their value.

However, while these risks remain, they're now adequately reflected in Caesars shares. If there is a favorable debt restructuring that results in modest or minimal equity issuance, Caesars shares could rise sharply. Being short Caesars stock now looks dangerous.

This morning, Caesars sued a group of the second-lien holders, arguing the bondholders have attempted to "thwart CEOC's restructuring efforts through actions apparently designed to push CEOC into default," according to a press release. Caesars went on to say that it has worked "collaboratively and constructively with debtholders to improve CEOC's financial condition…" The latter statement is amusing because Caesars and its private-equity sponsors have played hardball ever since the company went private in a $30 billion leveraged buyout in 2008 that left the company over-leveraged when the financial crisis hit.

Caesars' strategy in recent months appears to have been designed to weaken the standing and credit support of the second-lien debt in order to effectuate a restructuring of that debt at low levels and thus minimize any equity dilution. Specifically, Caesars moved in May to remove its own guarantee on the second-lien debt, thus removing key credit support for the debt.

In a report last week, Fitch Ratings wrote that a "CEOC default likely is near." The rating agency went to say that it "believes CEOC will attempt to execute a debt-for-equity exchange with the second-lien holders in the near-term." Fitch also touched on some of the challenges facing Caesars: "The second-lien's elevated price relative to recovery prospects is hampering CEOC's exchange efforts."

Imperial Capital analyst Gregg Klein wrote last week that Caesars wants to swap equity in CEOC for the second-lien debt, but that the bondholders are likely to "resist" any such move because Caesars has "already transferred most of its higher quality and growth assets" out of CEOC. Moreover, CEOC probably would carry sizable debt even after any restructuring, meaning that equity value could be modest at best. Nearly all of Caesars' Las Vegas assets have been transferred out of CEOC. Caesars recently sold a small amount of equity in CEOC.

CEOC has about $12 billion of first-lien debt, or $9 billion of net debt after reflecting $3 billion in cash (mostly from disputed asset sales). That's about eight times its $1 billion-plus in estimated annual cash flow. Then there is the $5.3 billion of second-lien debt.

The second-lien bondholders allege in their suit that a series of asset transfers were done at "less than adequate consideration" as Caesars moved assets from an indebted CEOC to two healthier entities, Caesars Entertainment Resort Properties (CERP) and Caesars Growth Partners. The latter is partly owned by the public Caesars Acquisition Co. (
CACQ
) whose shares traded around $11.25.

Two transactions that look particularly attractive to Caesars—and unattractive to bondholders—were the sale last year of two Vegas properties—the Linq shopping and retail complex and the Octavius tower at Caesars Palace—for about $600 million in consideration. That deal could have been done at about five times estimated annual cash flow, roughly half the typical Vegas multiple.

And Caesars' move in March to make available the company's Total Rewards, a valuable loyalty program, to all Caesars entities for what bondholders allege is little compensation is a blow to CEOC, which has controlled the loyalty program. The bondholders call Total Rewards a "crown jewel" because of its popularity with Caesars guests, who can earn free or discounted nights at Vegas hotels and other benefits, from patronizing Caesars properties around the country. Conceivably, CEOC second-lien bondholders could use access to Total Rewards as a bargaining chip in any restructuring talks, but Caesars has sought to quash that.

The Caesars situation is likely to remain contentious because there doesn't appear to be a restructuring plan that will satisfy both the second-lien bondholders and the private-equity firms that control Caesars. Look for more fireworks in the coming weeks.

Caesars: Is Worst Over?

The battle is heating up between Apollo Global Management and TPG Capital, the big private-equity firms that control Caesars Entertainment (ticker: CZR), and a group of Caesars bondholders that includes some well-known hedge funds, including Appaloosa Management and Oaktree Capital.

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